The time is right for globally diversifying your income sources
Amid today’s rising rate environment and with an aging credit cycle, U.S. fixed income investors are navigating a new period of uncertainty. The good news is that within our changing world, the fixed-income markets of today are global and can offer many different ways to use diversification to enhance returns and mitigate downside risk.
Where U.S. fixed-income investors might have traditionally sought refuge in shorter-duration or lower-beta strategies, or perhaps considered an unconstrained fixed-income approach or specialist manager in a niche market to achieve their desired outcome, we believe that investors would be better served by proactively embracing global markets in their fixed-income exposures.
Over the past 20 or so years, we believe that fixed-income investors have experienced three distinct shifts in perceived risk. From the mid-1990s until 2005, the environment was a period where risk was more balanced with periods of “risk on” and “risk off.” Then, from 2005 to 2008, most were caught off guard as the sub-prime/credit crisis began to unfold. This presented good entry points as the U.S. economy began to recover. For the past nine years, U.S. fixed income has been a good place to be once again from a risk standpoint.
Today, the interest-rate cycle appears to be turning with the U.S. leading rates higher. The yield on the U.S. 10-year Treasury has risen to levels not seen in nearly five years, and there are growing signs of pressure on rates outside the U.S. While the global trend in rates might be higher, investors with the flexibility to invest in differing rate regimes may be able to find more places to hide than those whose allocation is comprised primarily of domestic bonds.
Higher rates, along with the potential for the end of a credit cycle, threaten to diminish the value of a bond’s coupon income, a major source of return for fixed-income investors. Bondholders relying on coupon income will need to find ways of dealing with the uncertainty of this new environment. Unfortunately, most investors will aim to generate higher returns by choosing to be overweight to “risk assets” (or non-U.S. Treasury sectors) in the U.S. fixed-income universe regardless of the current environment.
The problem with this philosophy is obvious. At the exact point when you need your fixed-income exposure to be the ballast in your portfolio during a period of equity underperformance, the “spread sectors” (or risk assets) typically underperform along with equities, providing you with equity-like risk at the exact time that you are looking for the something in your portfolio to mitigate this risk.
By having a more global orientation to a fixed-income portfolio, investors will feel less of an impact from the interest-rate and credit cycles of individual countries.
Therefore, a genuine understanding of these risks and how to manage them is imperative. One way investors may mitigate some of the risks experienced when investing in U.S. fixed income is to consider adopting a more globally diversified allocation.
Benefits of going global
Going beyond domestic fixed income allows investors to benefit from differences among countries in terms of where they are in their economic cycle to help look for both relative value and absolute total return opportunities. By having a more global orientation to a fixed-income portfolio, investors will feel less of an impact from the interest-rate and credit cycles of individual countries.
While there is an overarching global economic cycle, some countries will lead the cycle and some will be laggards. Having a global allocation allows investors to have exposure to all of these moving parts. Non-U.S. bonds can also be a positive during a weaker dollar environment like the one we have seen over the last few years. When the dollar weakens, non-U.S. securities become more attractive. Diversifying into international fixed income works not only for the upside, but also for the downside, in that diversification can help make portfolio returns more stable over time.
Letting go of home bias
U.S. fixed-income investors typically have a significant home country bias, which has historically been justified by both the U.S. rate sensitivity of liabilities and the sheer size of the U.S. markets. While the U.S. comprises 41% of the global bond market as measured by the Barclays Bloomberg Global Aggregate Bond Index as of April 2018, U.S.-domiciled bond investors commonly hold 80% or more of their fixed income exposure in domestic, U.S. dollar fixed income. Having such a large allocation to domestic bonds may have some merit depending on investors’ objectives, but it can also mean missing out on ways to achieve further diversification within a fixed income portfolio.
The global bond market continues to grow and develop, offering compelling return-generating opportunities worldwide. Liquidity, and the premium attached to having liquidity, is often an important input when making portfolio allocation decisions. One of the historic arguments in support of allocating to the U.S. has been that markets outside the U.S. are dwarfed by the domestic market and will therefore be liquidity-challenged in volatile environments. While the U.S. today remains the largest single market in the world, the size of European and emerging credit markets is on par with historic comparisons of U.S. markets.
In 2008, the U.S. high-yield market – which was around $600 billion as measured by the Bloomberg Barclays U.S. High Yield Corporate Index – represented nearly 75% of global high-yield markets, with the bulk of the balance made up primarily of emerging-markets corporate bonds issued in dollars or euros and comprising a component of about $250 billion. Roll the clock forward 10 years to today, and the size of the global high-yield market totals over $2.5 trillion – with emerging markets alone representing over $1 trillion and European high-yield bonds coming in at over $400 billion. Within this context, investors seeking yield shouldn’t feel confined or constrained by the U.S. high-yield market.
The changing face of emerging-market debt
So much has changed over the last 30 years, particularly in emerging markets. Reform-minded governments, conservative central-bank policies and vast potential for economic growth through domestic consumption have helped stabilize these countries and their economies. Whether through exposure to hard currency bonds, local currency bonds, corporate bonds or a blend of the three, emerging-market debt offers many attractive opportunities for investors.
More competitive issuance is starting to come from emerging markets, with better yields and spreads compared to developed-market bonds with similar credit quality. Constrained by rating agencies’ sovereign ceiling policy, the credit ratings of emerging companies are capped by the sovereign rating of their country of domicile; however, investors shouldn’t be put off by this. Currently, there are more opportunities to help investors diversify their portfolios and, in our view, improve their risk-adjusted return profile when they invest in emerging-market debt.
Enhancing a core allocation
The way that institutional investors construct their core allocations has changed dramatically, resulting in shifts away from traditional, U.S. Aggregate-based core and core plus mandates. Instead, corporate plans are allocating to long-duration and liability-driven strategies, while other institutional investors are looking at how they can target some of the more desirable aspects of a fixed-income allocation: income, safety and diversification without taking on unwanted exposure to credit or interest rate risk. We think that global fixed-income markets—whether they are developed or emerging, investment-grade or high-yield—can offer investors the tools they need to successfully manage to these outcomes.
Opportunities are everywhere
Investors have important decisions to make on this front, but they should start by reviewing their overall asset allocation to see where they might be lacking exposure to global and higher-yielding segments of the fixed-income markets. From there, they can decide whether one or more managers will fit best in obtaining their objectives. Opportunities for diversification are everywhere, provided investors – and their managers – are looking beyond their backyard.
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